Just last week, Second Life, an online virtual world, banned unregulated banks from its cyber-realm. Linden Labs, the operator of Second Life, announced that only banks or other financial institutions (such as investment companies and credit unions) that have a real-world presence and are licensed and regulated by real governments (U.S. or foreign, apparently) would be allowed. Second Life has said it will verify this status by requiring "an applicable government registration statement or financial institution charter."

Previously, banks could exist solely within Second Life. Thus, in theory at least, a customer's deposits or investments were governed only by their agreements with Second Life and with their cyber bank there.

Banks on Second Life accept deposits of Linden dollars, Second Life's currency, which is convertible into real U.S. dollars. As I discussed in a previous column, bank failures and frauds on Second Life have caused its citizens to lose some funds. . According to Linden Labs, it has also received complaints about several in-world "banks" defaulting on their promises of very high interest rates.

Plainly, Second Life's hope regarding the ban is that banks with real-world presences will operate safely and not defraud consumers. And in theory, Second Life's ban is a good idea. But in practice, as I will explain in this column, it may be unnecessary at this stage; will surely cause more confusion for regulators and Second Life citizens alike; and may not stop fraud.

Moreover, there was an interesting alternative that might instead have been employed: Linden Labs might have allowed its participants to create their own regulatory schemes - tailored to the geographies and customs of Second Life.

Why Confusion Will Predictably Result from the Ban

The ban might seem simple: Show us your registration statement, or you cannot do business here on Second Life. In practice, however, its enforcement will be anything but simple. Here are just a few of the questions that will result:

Will Linden Labs expect financial regulators to police or monitor activity within Second Life?

Financial institutions have to maintain reserves with the Federal Reserve or other central banks, to protect the bank and the banking system in the event that there is a run on currency or a panic. Will reserve requirements have to be rewritten to include Second Life deposits in Linden dollars? Will Second Life deposits be eligible for FDIC deposit insurance?

Will real-world bank examiners now need to monitor what sort of lending a bank does in Second Life, or what sort of interest it is paying its customers? What if two banks want to merge in Second Life?

Will Linden allow licensed banks from anywhere in the world to open up shop? What about banks of countries that are offshore havens for money laundering and tax evasion? Will we have a parallel "offshore" universe in Second Life?

Will Second Life itself become a haven for money laundering? And will banks or branches within Second Life have to fill out money laundering reports and file them with relevant authorities?

All of these questions need answers. Thus, Linden Labs will need, for example, to talk to regulators to figure out what sort of relationship regulators want to have (or should have) with Second Life.

Moreover, another important, related question is raised: Linden dollars have been treated as a purely virtual currency - used within Second Life, although capable of conversion on the Linden exchange. By limiting entry to real banks, Linden dollars may become more like real currency, as customers may transfer funds between their bank accounts in the real world and Second Life freely and easily. Once this happens, the Linden dollar looks much more like a widely-accepted medium of exchange, which may trigger a concern about offering a currency other than U.S. currency. (I discussed this issue in greater detail in my prior column on the "Ron Paul dollar").

Another Interesting Option: Creating Regulatory Bodies within Second Life

Ultimately, I believe that Second Life would have been better off allowing its citizens to think for themselves regarding their investments. The whole idea of Second Life, after all, is to provide an alternative world, not an extension of the real one.

Interestingly, prior to the ban, certain Second Life citizens and participants were considering forming their own regulatory bodies within Second Life. Groups could create their own chartering systems and rate banks, and even examine them to ensure compliance.

Of course, Second Life regulators might themselves be lax in monitoring the banks or might even collude with banks. But, at the end of the day, we cannot protect everyone from their own bad decisions. If consumers want security, they should put their money in banks in the real world. If they wanted to speculate or try something new, Second Life was once a place for experimentation with potentially new and better system. In the realm of banking, however, Linden has chosen to curtail experimentation in favor of imposing real-world regulation, which is a shame.